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Market volatility is back with a vengeance. And until it calms down, which right now it's in no mood to do, volatility is likely going to increase.
The triple-digit moves in the Dow Jones Industrial Average we're seeing almost daily are telling.
They're telling us that markets are nervous, very nervous. The constant jumping out with both feet and jumping back in with both feet is indicative of nervousness. Investors are jumping out because they don't want to get caught in a correction, and they're jumping back in because they don't want to miss the next leg up.
However, things aren't exactly what they seem to be. The jumping in and out isn't being done by individual investors - it just looks that way. And that itself is even more telling, but of something completely different.
Here's the truth about the new volatility. First of all, it's part of the system now. Second, volatility will always increase when markets head south or when nervousness pervades.
Market volatility has many meanings, and how you slice it and dice it or measure it is another conversation, and a long and complicated one. But there's a simple understanding of volatility that you absolutely must grasp and not let go of. All other means of describing volatility are part and parcel to the essence of the new volatility.
The "new volatility," which I'm coining here and now, refers to the big moves (with "big" always being relative) that stocks make. Stocks come first. There is no "market" without individual stocks.
Stocks all have a bid and ask. In normal times, there are investors and traders bidding for (wanting to own) shares at prices they want to buy them at. And there are offers, prices that investors and traders want to sell shares or short-sell shares at. The difference between a bid and an offer, meaning the two prices, is called the spread.
Whenever there is nervousness, especially when a stock, stocks, or the market is going down, spreads "widen."
The reason spreads widen is straightforward.
Say you're an investor, or a trader, or a market-maker (I'll get to market makers) and you are bidding for stock and prices are falling. You're not going to be so anxious to put up a price at which you are willing to buy shares if you think you can pull your bid and buy shares lower as the price falls.
Because sellers still want to sell and buyers are getting out of the way, when a bid shows up at a lower price, sellers will quickly "hit that bid" (meaning sell to that bid) to unload their stock, or short the stock if they think prices are going lower.
Market makers (and I made markets on the floor of the Chicago Board Options Exchange and as an "upstairs" trader in stocks and other instruments) are designated (subject to regulators) traders in certain stocks. A market maker's job is to always post a bid and offer in the stocks he or she makes a market in.
Specialists on the New York Stock Exchange are market makers, too. If you get that, you know that market makers have to be willing and able to both buy and sell the same stock at the prices they've posted. They have to.
Now, if you're a market maker and the stock you make a market in is falling, are you going to keep bidding for stock and keep buying stock as the price falls? Of course not.
So what do you do? You widen your spread, making it as wide as you can within the rules that govern those parameters (wink, wink).
Welcome to the New Normal - and the New Market Volatility
The new volatility comes from wide spreads that are inherent in the new normal market. The new normal market has wider spreads than anyone really sees - until panic occurs, and then everyone sees how wide they get.
That's because there just aren't a lot of bidders and sellers lining up anymore. When I say they are not lining up, that doesn't mean they're not there - it means they aren't putting down their orders anywhere.
We now have 14 exchanges here in the United States, where we once had one, the NYSE, then two with the American Stock Exchange (AMEX), then some other little ones, and finally three big ones when the Nasdaq Stock Market computerized exchange came online. On all these exchanges, investors and traders can send their orders - mostly to places that will pay them to execute in their houses.
And because stocks now trade in increments of a single penny, investors and traders don't put down orders and just leave them out there.
The advent of decimalization on top of an increasing number of trading venues and what the confluence of those two had on volatility is a remarkable story, one for another time. But suffice it to say, they resulted in more inherent volatility.
Even when the spread in a stock looks tiny, and you think that means there's a lot of liquidity there, you're being fooled. What's more important than the actual spread is the "depth of the market," or how many shares are being bid for at that bid price and how many shares are being offered at that offer price. That's what's important.
That seemingly "tight" spread can widen in a nanosecond if there aren't any bidders lining up to buy stock.
That's where volatility comes from. The big moves aren't necessarily the result of a lot of volume of shares being traded (although that certainly adds to volatility at times).
The new volatility inherent in the system results from the fact that spreads widen really quickly. Both on down days when investors are anxious to get out at any price and on big up days when investors will pay up to get into a stock.
Volatility moves stocks quickly in either direction. The new volatility means that, even on the quietest days, volatility can spring to life in a nanosecond.
What the recent volatility, meaning the triple-digit moves in the Dow, indicates is that investors and traders are nervous and don't know what the market's next direction will be.
Because the market system has embedded new-volatility characteristics that will cause prices to gap up and gap down, we should all take the increasing market volatility as an early warning sign.
Whenever markets are this nervous, it's time to be cautious and make sure you have an exit plan, or at least a strategy to hedge any positions you have.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.